Chartered Financial Analyst Level 2

Explanation

The historical approach to estimating equity risk premiums (ERP) uses a government bond yield as a proxy for the risk-free rate.

Key Points:

• Historical Approach: This method calculates ERP by comparing the historical returns of equities with the historical returns of risk-free assets (typically government bonds).
• Government Bond Yield: Long-term government bond yields are commonly used as the risk-free rate benchmark in this calculation.
• ERP Calculation: ERP = Historical equity returns - Historical risk-free rate (government bond yield)

Why Other Options Are Incorrect:

• Macroeconomic models (A): These are used in forward-looking approaches, not historical approaches.
• Dividend discount models (B): These are used in implied ERP calculations, not historical ERP calculations.

Historical ERP Formula:

ERP = Average historical stock returns - Average historical government bond returns

ERP = Average historical stock returns - Average historical government bond returns

This approach relies on actual historical data rather than forward-looking estimates or models.